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How to Raise Capital for Free (Thanks to Carbon Trading)

No, that headline isn’t wrong. And no, it’s not a trick to get you to read this posting (although hopefully it helps). While reporting for a recent article on Europe’s cap-and-trade carbon dioxide market, I came across an eco-financing trend that could have implications when/if the U.S. unveils its own federally-mandated emissions trading scheme.

In short, Europe’s heavy industry, such as oil refiners and steel manufacturers, has turned the Continent’s carbon market into a new source of financing to cover running costs. The move comes as traditional credit markets have practically shut down in response to the growing global recession. Since last summer, European companies have flooded the European Union Emission Trading Scheme (ETS) with excess allowances in an attempt to raise much-need capital. And because governments doled out these CO2 credits for free, the fire sale has given firms access to billions of dollars of funds for almost zero additional cost.

“They are using [carbon] allowances to raise cash because it’s so hard to get capital from banks,” says one market analyst, who declined to be named. “The lower demand for manufactured products means companies will have no trouble meeting their own offsetting obligations, so can sell excess allowances for a tidy profit.”

Indeed, the wholesale dumping of CO2 credits into Europe's carbon markets, coupled with falling commodity costs, has shaved 70% off the ETS' price since July, 2008. For sure, the slide has slashed how much money companies can raise, but selling carbon emissions still represents a better financing option than the credit markets, which continue to demand costly interest rates.

Aggravating the sale is Europe's drastic cutback in industrial production, which means companies already are emitting less than their allocated CO2 targets. The Continent's steel output in December, 2008, for instance, fell 42% compared to the same period a year earlier. Researchers at New Carbon Finance even reckon 30% of Europe's 2008 total carbon reductions was due to manufacturing cutbacks linked to the recession. That compares to 40% related to carbon trading.

Yet even as Europe's heavy industry piles into this new financing opportunity, some caution the Continent's steel makers and cement manufacturers could be putting short-term gains over long-term risks. Selling CO2 credits does provide easy capital, but also could leave firms short of allowances when industrial production finally picks up (possibly by the end of 2009). That means companies that sold credits for, say, $12 per metric ton, could end up having to buy back allowances next year at a 20% to 30% markup.

"Heavy industry players are liquidating allowances for cash, but any pickup in [manufacturing] output could leave them scrambling to cover their [carbon] exposure," says one European carbon trader.

That, in turn, could lead to a spike in carbon prices as drastic as the recent two-thirds dip in CO2 contracts. This volatility, though lucrative for financial players active in the ETS, doesn't help companies make long-term, low-carbon investment decisions.

So what lessons does this provide for the U.S.? Firstly, no one is saying carbon-market participants shouldn't have the right to monetize their CO2 allowances. In the end, that's what a cap-and-trade system is all about. Yet many European market-watchers say a more stringent allocation of carbon credits would limit the large-scale price swings that have come to epitomize Europe's foray into emissions trading. Full auctioning, in which companies aren't given free CO2 credits, but instead must bid against each other for allocations, also could stop firms' wind-fall profits from carbon.

Most importantly, policymakers must recognize that any form of cap-and-trade system inevitably will lead to unintended consequences. When Europe's scheme was created back in 2005, no one thought it would evolve into a more traditional form of capital market only five years later. Ahead of any U.S. scheme, Obama & Co. must keep that in mind -- and be ready to deal with unforeseen events that almost certainly will arise.